The Days Ahead:

  • Inflation and small businesses report

This Week:

  • Japan has started to retreat from controlling the bond market.
  • It’s a slow process but will change the outlook in a good way.
  • Meanwhile the Japanese economy and stock market are steady.
  • Fitch issues a downgrade for U.S. debt.
  • Then didn’t tell us anything new.
  • But the market woke up to some issues that have been in the background.
  • Stock and bond markets eased…nothing to worry about

Japan Did a Thing.

If you’ve avoided the Japanese stock markets since 1988, you haven’t missed anything. Sure, there were some trading opportunities in and around cycles. If you timed it right, you could have made 25% to 30% gains in 1995, 1998, 2003 and 2012. But each time the market reset lower. The full gain from December 1990 to now is, well, less than zero.

An investment in the S&P 500 (top line in the chart) would have returned 8.2% a year or $1,386 on a $100 investment. It’s a depressing chart if you grew up admiring Japanese business methods and products but here it is.

The chart is only the price changes in stocks. If we included dividends for both markets, the results will favor the S&P 500 even more.

Other Japanese asset classes fared as badly. The average price of Tokyo condominiums was ¥70 million (around $540,000) in 1990 and is ¥69 million (around $485,000) today. Japan’s 10-Year Government bond fell from around 4.3% in 1992 to a low of -0.25% in 2016 but they haven’t been above 2% since 2006 or 1% since 2016.

The big and persistent problem has been deflation. That’s when nominal GDP growth is lower than real GDP growth. And the only way to feel richer is if your wages stay still and the price of everything around you collapses. But as we’ve mentioned before, if you’re in a deflationary economy you end up postponing purchases because everything is cheaper tomorrow. In an inflationary economy, you spend on things, property land…anything to get rid of the money. Things are more expensive by the day. An inflationary economy at least moves. You have an incentive to spend. A deflationary economy remains stuck. There’s no incentive except to hoard.

And that’s what happened in Japan. The one chart we’ve never seen in the U.S., is one that looks like this.

The blue line is Japanese nominal wages which have fallen 9% since their peak. It spikes up and down a lot because Japan uses a bi-annual bonus system which means the numbers don’t smooth out. However, the back line is smoothed out and adjusts for inflation. It shows real wages down 17%. In contrast, nominal hourly wages in the U.S. have only fallen once since 1940 and that was for a few months in early 2020.

It’s a remarkable trend and one that has never been seen in western economies since at least the Great Depression and, even then, it didn’t last 30 years.

For years, then, the Bank of Japan (BOJ) and several governments have tried to move inflation above 0%. The only time they were able to do so was when new sales taxes came into effect and temporarily boosted prices. But higher sales taxes just seemed inflationary for a few months. Prices soon fell again.

The main tool to boost inflation was the BOJ’s monetary policy which came in three parts.

First, it used massive amounts of bond buying, to the point where it now owns $5.2 trillion of government and corporate bonds, loans, real estate and ETFs. It also owns around 45% of all public debt.

Second, it set rates at zero and below from 2009 on.

And third it implemented a new form of rate targeting called Yield Curve Control, where the BOJ set the price of the 10-Year Government bond to 0.00% in 2016, 0.25% in 2018 and finally 0.50% at the end of 2022.

Throughout the Covid-19 period, the jump in inflation that followed the reopenings, and the subsequent increase in rates from nearly every central bank in the world, the BOJ kept policy rates firmly at zero and the 10-Year government bond at a fixed rate. It was like Japan was living in its own world. It was desperate to see inflation rise and stay up. The rest of the world wants to see inflation fall and stay down.

Last week came news that the BOJ will now let the 10-Year Government Bond rise to 1%. That’s a big change and could have major ramifications.

Here’s a quick Q&A.

What did they do? In the policy statement, they changed the word “limits” to “references.” Limits meant they allowed the 10-Year bond to fluctuate only between -0.5% to 0.5%. Those rules are now a lot less rigid. They also said they would buy bonds at 1.0%. It’s not a policy any other central bank has used and can be confusing. But the bottom line is that 10-year government bond rates will be allowed to rise to 1.0%.

We’d note here that being allowed to and actually happening are two very different things. The BOJ has no interest in disrupting the bond market and watch prices fall by 5% or more. Just to show who’s boss they waded into the markets on Monday with $2 billion of bond purchases to make sure the 10-year bond didn’t rise above 0.6%.

Why did they do it? Inflation is slowly moving in Japan. It finally rose above 0% for the last two years and above 2% for the last year. The Bank is not convinced it won’t slip back but feel it is at least moving in the right direction. Full time jobs are growing, even as the population falls, and wages are increasing. Labor union wages rose 3.6%, a 30- year high, and even the minimum wage rose for the first time since 2015, and by over 3%.

It’s still only 1% and the U.S. 10-year U.S. Treasury is at nearly 4%, why the fuss? Because Japan is a very big saver and buyer of international bonds and U.S. Treasuries. It is the largest foreign holder of U.S. Treasuries with just over $1.0 trillion, or 4% of public debt. It also holds another $1.0 trillion in U.S. corporate bonds and $1.0 trillion in mortgage-backed securities and European sovereign bonds. For years, a Japanese investor could fully hedge an overseas bond and still end up with a yield 2% over what was available in Japan. Those yield premiums are a lot lower now because Japanese bonds yield more and the cost of the hedge has gone up. The fear is that demand for foreign, and especially U.S. bonds, will fall away.

Ok, will Japanese investors stop buying U.S. Treasuries and bonds? No. First, Japanese investors are very big savers. They are a creditor nation. They must invest somewhere. Stopping is not an option. They now have three choices.

One, they invest in domestic bonds at still-low rates and risk capital loss as rates drift up.

Two, they buy U.S. Treasuries and hedge back into yen and, given that forward hedge rates are so high, lock in an almost zero rate.

Three, they buy unhedged U.S. Treasuries and see if the yen weakens, which is what they’ve done most of this year.

So, where are we? We don’t have to worry about Japanese investors selling U.S. Treasuries. Sure, at the margin, they may buy less but this is not the start of a big reset in global bond markets.

We also don’t have to worry about the BOJ doing anything sudden. They’ve been trying for 30 years to move inflation off the zero floor and they want to make sure it stays there. They are not about to start a series of rate hikes like the Fed and ECB.

We expect the Yen to appreciate. It’s been very weak this year which means that for an international investor in Japan, the 28% return so far this year in Japanese stocks, converts to 18% for a U.S. dollar investor. Decent, but could be better if the yen strengthens.

We would also expect the economy to continue to improve. Full time jobs and labor force participation are both growing and wages finally moving.

The Bank of Japan is a very steady and conservative institution. It moves slowly. Last week was the first change in a decade. We’ve been cautiously optimistic on Japan this year even though it’s reputation as a “widow maker” (i.e., every upturn is a head fake) is well deserved. The latest move by the Bank of Japan helps the renewal but there’s still a ways to go.

Fitch Downgraded the U.S.

There are several credit rating agencies of which S&P, owned by S&P Global but formerly known as McGraw Hill, and Moody’s are the most famous. But there are others like Dunn & Bradstreet, Kroll. Morningstar, A.M. Best and Fitch. They’ve all been around for decades, are global, and basically do the same thing. They assess the credit of borrowers. They all use a ranking system that goes from some version of pristine, like AAA, all the way down to “D” for default. There are around 20 different ratings from top to bottom.

If you want to issue a bond to investors, you can try and do it without a rating but investors will assume you’re hiding something, the rating agencies will mark it as “not rated” and it will be very expensive. (That’s mostly true…there are exceptions) So, bond issuers pay the rating agencies to rate their bonds and investors pay the rating agencies to read the ratings. It’s a nice business. You want to borrow money but you can’t without a rating report. And you want to buy a bond but you can’t, or at least it’s very risky, if you don’t can’t get hold of a rating report.

If that sounds like a very nice business and should be regulated, you’d be right, and they are. They came under intense scrutiny in 2008 when they were accused of, well, being “key enablers of the financial meltdown”. Their reputations were in tatters and a host of new rules came into effect, such as not allowing a rating agency to rate a debt issue that it had advised on, not charging more for a favorable rating, requiring documentation on how often and why they changed ratings and showing the subsequent performance of the bonds they rated. You know, pretty basic stuff.

With that, rating agencies said “Ok, fair cop” and retreated back to where they liked to operate, out of the public eye.

That is until August 2011 when S&P downgraded U.S. Treasury debt from AAA to AA+, citing political brinkmanship around the debt ceiling, and the inability of Congress and the Obama administration to agree on fiscal policy or revenue increases.

This earth-shattering announcement was greeted with a lot of criticism but was mostly ignored by the credit markets. Here’s the chart for 2011.

The highlighted circle on the upper graph shows that spreads widened, meaning corporate bonds yielded 0.40% more than the 10-year Treasuries at the end of the month than at the beginning. If investors were truly worried about U.S. credit, those spreads would have gone in the other direction. Other credit sensitive markets like the U.S. dollar, the price of U.S. credit defaults swaps, money market funds and the subsequent move in Treasury prices, all pointed to a collective shrug to the S&P announcement.

Stocks, however, fell around 8%, went sideways for a few months and then rallied 20% from a September low.

Since then, the rating agencies have warned about debt ceiling brinkmanship, government closedowns, increasing debt and interest costs but no one actually issued a downgrade… until Wednesday.

Fitch downgraded the U.S. debt rating from AAA to AA+. You can read the release here but it basically says much of what S&P said 12 years ago. The U.S. had too many “debt limit standoffs and last-minute resolutions”, debt and spending are too high and there were no plans to raise revenues (i.e., taxes).

No argument there. Anyone sitting through the last debt ceiling negotiations would concede some of Fitch’s points. The budget deficit was around $1,300 billion last year or 5.5% of GDP. That’s a whole lot better than 2021 when it was 12% of GDP but then the economy was only slowly emerging from the big hit to GDP in 2020.

The CBO doesn’t update the budget forecasts frequently and the final number for 2023 will almost certainly be better than the 5.8% they penciled in back in May. We know this because the $380 billion cost of cancelling student loans was paid up front and, from the recent Supreme Court decision, that isn’t going to happen. Still the deficit is sitting there at a time when it should be going down given the advanced stage of the cycle.

So, Fitch may be right but here are some thoughts:

What did they do? They downgraded debt issued by the U.S. That means Treasury debt. They did not downgrade the U.S.’s “country” rating of AAA. This means that debt guaranteed by the U.S. government, but issued by the likes of Fannie Mae, Freddie Mac and the Federal Home Loan Banks, remain at AAA. There’s a logic to that. The debt is subject to ceilings and taxes. The guarantees are backstopped by the U.S. government but are not direct obligations of the U.S. They don’t, for example, show up in the Treasury’s list of debt obligations. So, Fitch says, a guarantee from the U.S. is less risky than the debt from the U.S. I know, it’s weird.

Did Fitch say anything we didn’t know already? No.

Why did they do it now? Good question. They put out a “credit watch” in May and since then Congress and the Biden administration addressed the issues raised. So, slow day at Fitch? Anything for a headline? Prepping for the September budget discussions?

Does this make Treasuries less attractive to borrowers? No. The U.S. Treasury market is very deep and very liquid. Investors use them for total return, liability matching, inflation proofing (the TIPS), collateral, lending benchmarks and swaps….plus a dozen other reasons. The demand for Treasuries will be there despite the downgrade.

Will there be any forced sellers of Treasuries? No. Some investors like money market funds, pension funds, or government securities funds as well as bank capital rules used to require a minimum rating of AAA. However, many of those investors, changed that to “government bonds” in 2011. So, no, we don’t expect any investors will need to offload Treasuries as a result of the decision.

If the U.S. is now AA+, who has a better credit rating? A lot. All the bonds guaranteed by the U.S. government as well as the European Union and over a dozen countries like, Germany, Luxemburg, Singapore and Switzerland carry a higher rating.

So do 15 states, many counties in California, including the city of San Francisco, and a handful of companies. That doesn’t mean that a AAA rated company like Microsoft can borrow more cheaply than the U.S. Treasury. They can’t. A 30-year bond from Microsoft currently yields around 4.7% and a 30-Year U.S. Treasury yields 4.2%.

Normally a downgrade means debt becomes more expensive for the issuer but this is rarely the case with sovereign bonds. Japan carries a rating of “A” and it borrows at a rate 3.5% cheaper than the U.S. If a country issues bonds in its own currency, it will never default and, in our simple view, they should all be AAA or not rated. But there we go.

Will it affect the equity market? The S&P downgrade in 2011 affected equities but the economy was weaker then and there were 13.9 million people out of work and a 9% unemployment rate. The Fed was also about to launch “Operation Twist” which was another round of heavy quantitative easing. There was a lot more uncertainty and fear in markets than there is today.

Any criticisms this time round? Plenty. Secretary of the Treasury Janet Yellen was none too pleased. Other heavyweights like Former Treasury Secretary Larry Summers, Mohamed El-Erian and Paul Krugman weighed in basically saying “Why now” and “Why with the economy improving.” Larry Summers had the sound bite:

“The idea that this is creating the risk of a default on US Treasury securities is absurd, and I don’t think that Fitch has any new and useful insights into the situation.”

Of course, there were others in the “told ya” camp and pointed to the deficit. That’s a fair point but the timing is very odd. This is August! Treasury markets don’t do much in mid-summer.

How did the markets react? It’s tough to point to cause and effect because there’s so many other influences on the market. The 10-year Treasury rose about 0.2% to 4.2% but the U.S. Treasury announced a monster refinancing a few hours later, so that may have caused some of the market moves. The dollar strengthened slightly, credit default swaps didn’t change and foreign bonds didn’t rally, which you would expect if people became fearful of Treasuries. We think that demand for Treasuries will remain high. Stocks sold off but, then again, they’ve had a great run.

So, big nothing burger or a day to remember? More the first. As we’ve said, we don’t expect investors to exit Treasuries nor do we expect that the report means higher borrowing costs for the U.S. It may spur more talk about the deficit which has been simmering in the background but, overall, it’s not a cause for alarm.

The Bottom Line

We write this blog as of close of markets on Thursday, so in a fast-moving week like this one, it can feel stale by the time it reaches the inbox. But this is our take on the week when both bonds and stocks fell.

  1. Markets do not go up in a straight line. Stocks have had an unbroken run since March. Sometimes they take a breather.
  2. The market is digesting the changes in Japan. Japanese investors bought a lot more foreign bonds last week so they’re not about to retreat from the U.S. bond market.
  3. Fitch’s downgrade drew attention to the budget deficit and the upcoming negotiations.
  4. Markets are waiting for the jobs report and the claims number suggests it will be strong.
  5. Treasury issuance for the July to September period was announced at $1,007 billion up $274 billion from the last estimate and $657 billion in the April to June quarter. Again, this wasn’t a total surprise but sometimes the market ignores stuff like this and then suddenly wakes up.
  6. Some well-past his sell-by date, publicity seeking hedge fund manager came out and said he’s shorting the U.S. long bond. He’s actually buying put options but “shorting” sounds like he knows what he’s talking about. He doesn’t.
  7. The bond vigilantes are having their day in the sun.

We’ll cover the deficit and Treasury issuance next week. We don’t think it’s at a pain point, nor is it likely to be. But the budget and current account deficits, or twin deficits, come up every now and then and we may see a replay in October when Congress returns and budget fun begins.

Meanwhile, the S&P 500 is up 29% from its low last October and up 17% this year. The Nasdaq remains fully in bull market territory and stock market volatility is low.

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Art: Petra Cortright

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